Stress Testing at the International Monetary Fund: Methods and Models

(GFSR). Stress testing is also being undertaken increasingly in Article IV and crisis program work. Correspondingly, the demand by IMF member countries for technical assistance from IMF staff on stress testing has risen as well, as country authorities seek to develop and enhance their own capacity in this area. Th e global fi nancial crisis injected a dose of caution into the enthusiasm surrounding the usefulness of stress tests. It raised questions about the credibility of the exercises conducted in the runup to the crisis, many of which were unable to adequately capture the relevant risks and exposures and hence did not provide suffi cient early warning of potential vulnerabilities. Critics attributed the failures to poor data quality, weaknesses in scenario design, inadequate methods and models, or their incorrect application. At the IMF, lessons learned from the crisis have spurred staff to improve the robustness and versatility of stress tests. One of the main areas is improving the design and application of stress testing methods and models. IMF staff has developed new models and are adapting or calibrating existing ones to better capture the risks (including those that manifested during the crisis) and are working to ensure their consistent and appropriate use in diff erent settings. Th is volume puts together, for the fi rst time, the applied stress testing methods and models built or adapted by IMF staff , some in collaboration with external colleagues, before and during the crisis. Most chapters have previously been released as IMF working papers, while some have been published in refereed journal articles. Given the very technical nature of the material presented, this book is not for the fainthearted. But for those who are interested in understanding staff ’s stress testing methods and models, this book provides essential insight into the strengths and shortcomings of each technique and details the data required for implementation. S testing is a “what if ” exercise. It mea sures the sensitivity of a portfolio, an institution, or a fi nancial system to exceptional but plausible shocks. Th e answer involves identifying relevant risk drivers; selecting the appropriate method or model; using that par tic u lar method or model to calculate the eff ects of large shocks; and interpreting the results correctly. A number of studies provide a general introduction to stress testing, discussing its nature and purpose (e.g., Blaschke and others, 2001; Jones, Hilbers, and Slack, 2004; and Čihák, 2007). Stress tests are also being designed from another angle, which is to ask the question: What would it take to “break” a fi nancial institution or a fi nancial system? (e.g., Financial Ser vices Authority, 2009). From a technical perspective, stress testing has become more complex and sophisticated over time. A wide range of methods and statistical and mathematical models developed by academics and practitioners are now available for estimating the impact of various fi nancial or economic shocks on fi nancial systems. For potential users, the wealth of available techniques can be confusing— their relevance and applicability under diff erent conditions and situations may not be always clear, and it may not be obvious how they supplement or complement each other. Over the years, staff at the IMF also has developed a suite of stress testing methods and models, and has adapted existing ones, for use in their fi nancial surveillance work. Indeed, this area of macroprudential risk analysis has become a central aspect of IMF staff ’s assessment of individual fi nancial systems and of the international fi nancial system itself. It is a key component of the Financial Sector Assessment Program (FSAP) and has become an important part of the conjunctural and structural analyses in the Global Financial Stability Report